As Piotr Łabuz — psychologist, trader and financial mentor explains: “Mental accounting is a mechanism by which we code and control the sources of obtaining money and the purposes on which we spend it.” Depending on this, how we post a given income or expense, we will manage money differently. That is why we will spend less thoughtfully the money received as a gift or won in the lottery than earned by our hard work. People who have won huge sums in the lottery or inherited property in inheritance usually lose it quickly...

We turn out to be masters of “creative accounting” - especially on vacation. On vacation, we are willing to pay much more for waffles, restaurants or entertainment than we would accept in our hometown, since we book it as “vacation expenses” and not “expenses at the place of residence”. This also applies to people who live in tourist resorts.

The American economist Richard Thaler in the 1980s described this phenomenon of “mental accounting”, which contradicts the principles of classical economics and the theory of rational choice. By Thalera we create separate “mental accounts” in our minds, that is, drawers in which we place individual expenses and income. We do this in the same way as an accountant assigning successive income and expenses to different accounts. The purpose of such “stacking” of money in the mind is to feel more control over one's own finances and manage various groups of expenses and receipts.

In a financial coaching session, I work with clients on both analyzing their spending, but also their approach to money and the ways in which they do mental accounting. Aby To better manage finances, you need to change not only bad habits, but also beliefs and mindset.

Mental accounting causes us to show a completely different approach to money management in the private and professional spheres, although our personality, knowledge and competences in the field of finance are similar in both situations. Probably everyone knows people who manage their own funds very carefully and at the same time spend company or public money with a light hand... It also happens that someone meticulously keeps a statement of expenses and income in his company, and at the same time completely does not attach importance to it in the home budget.

Many psychological experiments have shown that Our financial decisions are inconsistent. For example: if someone wants to go to the theater, but loses a ticket that cost PLN 100, they are unlikely to buy a new ticket, because they will record this expense as “I have already consumed the entire budget I have for the theater this month”. And at the same time - if he loses PLN 100, it will not in any way reduce his/her willingness to spend this money on the theater, since the loss of the hundred-zloty banknote was not credited as “funds for the theater”. Therefore, it will take the opposite action, although in both situations the loss amounted to PLN 100.

Often, customers in restaurants are outraged when 5% is added to the price of dishes for service, even if they themselves always leave the waiters tips at a minimum of 10%. However, in the first case, this 5% is accounted for as a “compulsory surcharge”, and in the second as “my own desire to thank for good food”.

Mental accounting can be a trap and can lead to irrational decisions. This mechanism is used in sales and marketing. Advertisements and stores tempt us to do “mental reposting” and tempt us to shop. If we post more expensive cosmetics in the category “I am worth it”, instead of in the category of “unnecessary luxury”, then we will be more willing to make this expense.

More serious financial consequences are caused by the fact that many people, having deposited PLN 10,000 on a deposit, where the interest is, for example, only 5% per annum, at the same time take a short-term loan for PLN 10,000, although it is interest-bearing as much as 15% per annum. Logically, it would be more profitable in this situation to withdraw money from a low-interest deposit and not take an expensive loan!

Another example is the different approach of many investors to spend profits on the shares they own. Winnett & Lewis (1995) noted that the propensity to consume profits is higher when a dividend is received than when the share price increases by an analogous value. Thus, investors treat profits received in the form of dividends paid to them differently than profits resulting from increases in stock prices.[1]

It is worth mentioning two basic principles of mental accounting:

The principle of profit distribution

It gives us more pleasure many small profits/rewards than one big one. This means that you will usually feel more pleasure receiving two raises of $250 than one of $500. On the other hand, if you go to a restaurant twice and pay 150 PLN each, you will experience greater satisfaction than if you only go once and spend 300 PLN. This also applies to receiving gifts. Three small gifts will usually give more joy than receiving one gift for the total price of the other three. Especially children will be more happy with a few cheaper toys than with one very expensive one. More about giving gifts I wrote in the article How to spend money to really feel happy?

The principle of combining losses

One A big loss hurts less than a few smaller losses. For example, one larger price increase will be easier for us to swallow than two smaller increases in a row, giving a total of that amount. On the other hand, if we lose 5 thousand PLN on the stock exchange once, then we will usually recover faster mentally than if we lose 2, 500 zł twice in a short time. With a one-time loss, it is easier to say to yourself that “it was just an accident at work” and maintain a sense of self-competence as an investor than when we bet badly on the stock market twice.

It happens, that we mentally record profit as loss and instead of joy, we feel bitterness! It happens when the boss promises us a raise of 500 PLN, and in the end he gives only 200 PLN. Although we earn $200 more, we will rather be offended than grateful. And if both the promise and the increase amounted to PLN 200, then we will feel satisfied. Therefore, it is better not to make promises for growth and pleasantly surprise with an additional bonus, favor or faster execution of the order, than to do something still above the norm, but below the promise.

Everyone suffers from cognitive errors sometimes. We don't always make rational decisions. However, it is worthwhile to understand what traps and why we fall into, and to be more aware of our own beliefs and thinking patterns.

[1] “Mental accounting and its consequences” Piotr Zielonka, https://skarbiec.biz/inne/home-klitomsl-public_html-121-skarbiec-wp-content-uploads-skarbiec-domy-maklerskie-mentalne-htm.html